Monday, June 18, 2018

The Great Pension Train Wreck?

John Mauldin wrote a comment recently that caught my attention, The Pension Train Has No Seat Belts:
In describing various economic train wrecks these last few weeks, I may have given the wrong impression about trains. I love riding the train on the East Coast or in Europe. They’re usually a safe and efficient way to travel. And I can sit and read and work, plus not deal with airport security. But in this series, I’m concerned about economic train wrecks, of which I foresee many coming before The Big One which I call The Great Reset, where all the debt, all over the world, will have to be “rationalized.” That probably won’t happen until the middle or end of the next decade. We have some time to plan, which is good because it’s all but inevitable now, without massive political will. And I don’t see that anywhere.

Unlike actual trains, we as individuals don’t have the option of choosing a different economy. We’re stuck with the one we have, and it’s barreling forward in a decidedly unsafe manner, on tracks designed and built a century ago. Today, we’ll review yet another way this train will probably veer off the tracks as we discuss the numerous public pension defaults I think are coming.

Last week, I described the massive global debt problem. As you read on, remember promises are a kind of debt, too. Public worker pension plans are massive promises. They don’t always show up on the state and local balance sheets correctly (or directly!), but they have a similar effect. Governments worldwide promised to pay certain workers certain benefits at certain times. That is debt, for all practical purposes.

If it’s debt, who are the lenders? The workers. They extended “credit” with their labor. The agreed-upon pension benefits are the interest they rightly expect to receive for lending years of their lives. Some were perhaps unwise loans (particularly from the taxpayers’ perspective), but they’re not illegitimate. As with any other debt, the borrower is obligated to pay. What if the borrower simply can’t repay? Then the choices narrow to default and bankruptcy.

Today’s letter is chapter 6 in my Train Wreck series. If you’re just joining us, here are links to help you catch up.
As you will see below, the pension crisis alone has catastrophic potential damage, let alone all the other debt problems we’re discussing in this series. You are sadly mistaken if you think it will end in anything other than a train wreck. The only questions are how serious the damage will be, and who will pick up the bill.

Demographics and Destiny

It’s been a busy news year, but one under-the-radar story was a wave of public school teacher strikes around the US. It started in West Virginia and spread to Kentucky, Oklahoma, Arizona, and elsewhere. Pensions have been an issue in all of them.

An interesting aspect of this is that many younger teachers, who are a long way from retirement age, are very engaged in preserving their long-term futures. This disproves the belief that Millennial-generation Americans think only of the present. From one perspective, it’s nice to see, but they are unfortunately right to worry. Demographic and economic reality says they won’t get anything like the benefits they see current retirees receiving. And it’s not just teachers. The same is true for police, firefighters, and all other public-sector workers.

Thinking through this challenge, I’m struck by how many of our economic problems result from the steady aging of the world’s population. We are right now living through a combination unprecedented in human history.
  • Birth rates have plunged to near or below replacement level, and
  • Average life spans have increased to 80 and beyond.
Neither of these happened naturally. The first followed improvements in artificial birth control, and the second came from better nutrition and health care. Each is beneficial in its own way, but together they have serious consequences.

This happened quickly, as historic changes go. Here is the US fertility rate going back to 1960.


As you can see, in just 16 years (1960–1976), fertility in the US dropped from 3.65 births per woman to only 1.76. It’s gone sideways since then. This appears to be a permanent change. It’s even more pronounced in some other countries, but no one has figured out a way to reverse it.

Again, I’m not saying this is bad. I’m happy young women were freed to have careers if they wished. I’m also aware (though I disagree) that some think the planet has too many people anyway. If that’s your worry, then congratulations, because new-human production is set to fall pretty much everywhere, although at varying rates.

Breaking down the US population by age, here’s how it looked in 2015.


Think of this as a python swallowing a pig. Those wider bars in the 50–54 and 55–59 zones are Baby Boomers who are moving upward and not dying as early as previous generations did. Meanwhile, birth rates remain low, so as time progresses, the top of the pyramid will get wider and the bottom narrower. (You can watch a good animation of the process here.)


This is the base challenge: How can a shrinking group of working-age people support a growing number of retirement-age people? The easy and quick illustration to this question is to talk about the number of workers supporting each Social Security recipient. In 1940, it was 160. By 1950 it was 16.5. By 1960 it was 5.1. I think you can see a trend here. As the chart below shows, it will be 2.3 by 2030.


Similarly, states and local governments are asking current young workers to support those already in the pension system. The math is the same, though numbers vary from area to area. How can one worker support two or three retirees while still working and trying to raise a family with mortgage payments, food, healthcare, etc.? Obviously, they can’t, at least not forever. But no one wants to admit that, so we just ignore reality. We keep thinking that at some point in the future, taxpayers will pick up the difference. And nowhere is it more evident than in public pensions.

In a future letter, I will present some good news to go with this bad news. Several new studies will clearly demonstrate new treatments to significantly extend the health span of those currently over age 50 by an additional 10 or 15 years, and the same or more for future generations. It’s not yet the fountain of youth, but maybe the fountain of middle-age. (Right now, middle-age sounds pretty good to me.)

But wait, those who get longer lifespans will still get Social Security and pensions. That data isn’t in the unfunded projections we will discuss in a moment. So, whatever I say here will be significantly worse in five years.

Let me tell you, that’s a high order problem. Do you think I want to volunteer to die so that Social Security can be properly funded? Are we in a Soylent Green world? This will be a very serious question by the middle of the next decade.

Triple Threat

We have discussed the pension problem before in this letter—at least a half-dozen times. Most recently, I issued a rather dire Pension Storm Warning last September. I said in that letter that I expect more cities to go bankrupt, as Detroit did, not because they want to, but because they have no choice. You can’t get blood from a rock, which is what will be left after the top taxpayers move away and those who stay vote to not raise taxes.

This means city and school district retirees will take major haircuts on expected pension benefits. The citizens that vote not to pay the committed debt will be fed up with paying more taxes because they will be at the end of their tax rope. I am not arguing that is fair, but it is already happening and will happen more.

Let me say this again because it’s critical. The federal government can (but shouldn’t) run perpetual deficits because it controls the currency. It also has a mostly captive tax base. People can migrate within the US, but escaping the IRS completely is a lot harder (another letter for another day). States don’t have those two advantages. They have tighter credit limits and their taxpayers can freely move to other states.

Many elected officials and civil servants seem not to grasp those differences. They want something that can’t be done, except in Washington, DC. I think this has probably meant slower response by those who might be able to help. No one wants to admit they screwed up.

In theory, state pensions are stand-alone entities that collect contributions, invest them for growth, and then disburse benefits. Very simple. But in many places, all three of those components aren’t working.
  • Employers (governments) and/or workers haven’t contributed enough.
  • Investment returns have badly lagged the assumed levels.
  • Expenses are more than expected because they were often set too high in the first place, and workers lived longer.
Any real solution will have to solve all three challenges—difficult even if the political will exists. A few states are making tough choices, but most are not. This is not going to end well for taxpayers or retirees in those places.

Worse, it isn’t just a long-term problem. Some public pension systems will be in deep trouble when the next recession hits, which I think will happen in the next two years at most. Almost everyone involved is in deep denial about this. They think a miracle will save them, apparently. I don’t rule out anything, but I think bankruptcy and/or default is the more likely outcome in many cases.

Assumed Disaster

The good news is we’re starting to get data that might shake people out of their denial. A new Harvard study funded by Pew Charitable Trusts uses “stress test” analysis, similar to what the Federal Reserve does for large banks, to see how plans in ten selected states would behave in adverse conditions (hat tip to Eugene Berman of Cox Partners for showing me this study).

The Harvard scholars looked at two economic scenarios, neither of which is as stressful as I expect the next downturn to be. But relative to what pension trustees and legislators assume now, they’re devastating.

Scenario 1 assumes fixed 5% investment returns for the next 30 years. Most plans now assume returns between 7% and 8%, so this is at least two percentage points lower. Over three decades, that makes a drastic difference.

States are a larger and different problem because, under our federal system, they can’t go bankrupt. Lenders perversely see this as positive because it removes one potential default avenue. They forget that a state’s credit is only as good as its tax base, and the tax base is mobile.

Scenario 2 assumes an “asset shock” involving a 20% loss in year one, followed by a three-year recovery and then a 5% equity return for years five through year 30. So, no more recessions for the following 25 years. Exactly what fantasy world are we in?

Their models also include two plan funding assumptions. In the first, they assume states will offset market losses with higher funding. (Fat chance of that in most places. Seriously, where are Illinois, Kentucky, or others going to get the money?). The second assumes legislatures will limit contribution increases so they don’t have to cut other spending.

Admittedly, these models are just that—models. Like central banks models, they don’t capture every possible factor and can be completely wrong. They are somewhat useful because they at least show policymakers something besides fairytales and unicorns. Whether they really help or not remains to be seen.

Crunching the numbers, the Pew study found the New Jersey and Kentucky state pension systems have the highest insolvency risk. Both were fully-funded as recently as the year 2000 but are now at only 31% of where they should be.


Other states in shaky conditions include Illinois, Connecticut, Colorado, Hawaii, Pennsylvania, Minnesota, Rhode Island, and South Carolina. If you are a current or retired employee of one of those states, I highly suggest you have a backup retirement plan. If you aren’t a state worker but simply live in one of those states, plan on higher taxes in the next decade.

But that’s not all. Even if you are in one of the (few) states with stable pension plans, you’re still a federal taxpayer, and that’s who I think will end up bearing much of this debt. And as noted above, it is debt. The Pew study describes it as such in this chart showing state and local pension debt as a share of GDP.

For a few halcyon years in the late 1990s, pension debt was negative, with many plans overfunded. The early-2000s recession killed that happy situation. Then the Great Recession nailed the coffin shut. Now it is above 8% of GDP and has barely started to recover from the big 2008 jump.

Again, this is only state and local worker pensions. It doesn’t include federal or military retirees, or Social Security, or private sector pensions and 401Ks, and certainly not the millions of Americans with no retirement savings at all. All these people think someone owes them something. In many cases, they’re right. But what happens when the assets aren’t there?

The stock market boom helped everyone, right? Nope. States' pension funds have nearly $4 trillion of stock investments, but somehow haven't benefited from soaring stock prices.

A new report by the American Legislative Exchange Council (ALEC) shows why this is true. It notes that the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America. The ALEC report is far more alarming than the report from Harvard. They believe that the underfunding is more than 67%.

There are several problems with this. First, there simply isn’t $6 trillion in any budget to properly fund state and local government pensions. Maybe a few can do it, but certainly not in the aggregate.

Second, we all know about the miracle of compound interest. But in this case, that miracle is a curse. When you compute unfunded liabilities, you assume a rate of return on the current assets, then come back to a net present value, so to speak, of how much it takes to properly fund the pension.

Any underfunded amount that isn’t immediately filled will begin to compound. By that I mean, if you assume a 6% discount rate (significantly less than most pensions assume), then the underfunded amount will rise 6% a year.

This means in six years, without the $6 trillion being somehow restored (magic beans?), pension underfunding will be at $8.4 trillion or thereabouts, even if nothing else goes wrong.

That gap can narrow if states and local governments (plus workers) begin contributing more, but it stretches credulity to say it can get fixed without some pain, either for beneficiaries or taxpayers or both.

I noted last week in Debt Clock Ticking that the total US debt-to-GDP ratio is now well over 300%. That’s government, corporate, financial, and household debt combined. What’s another 8% or 10%? In one sense, not much, but it aggravates the problem.

If you take the almost $22 trillion of federal debt, well over $3 trillion of state and local debt, and add in the $6 trillion debt of underfunded pensions, you find that the US governments from the top to bottom owe over $30 trillion, which is well over 150% of GDP. Technically, we have blown right past the Italian debt bubble. And that’s not even including unfunded Social Security and healthcare benefits, which some estimates have well over $100 trillion. Where is all that going to come from?

Connecticut, the state with the highest per-capita wealth, is only 51.9% funded according to the Wall Street Journal. The ALEC study mentioned above would rate it much worse. Your level of underfunding all depends on what you think your future returns will be, and almost none of the projections assume recessions.

The level of underfunding will rise dramatically during the next recession. Total US government debt from top to bottom will be more than $40 trillion only a few years after the start of the next recession. Again, not including unfunded liabilities.

I wrote last year that state and local pensions are The Crisis We Can’t Muddle Through. That’s still what I think. I’m glad officials are starting to wake up to the problem they and their predecessors created. There are things they can do to help, but I think we are beyond the point where we can solve this without serious pain on many innocent people. Like the doctor says before he cuts you, “This is going to hurt.”

We’ll stop there for now. Let me end by noting this is not simply a US problem. Most developed countries have their own pension crises, particularly the southern Eurozone tier like Italy and Greece. We’ll look deeper at those next week.

This is not going to be the end of the world. We’ll figure out ways to get through it as a culture and a country. The rest of the world will, too, but it may not be much fun. Just ask Greece.
Ah Greece, once land of great philosophers, heroes and warriors, now reduced to the land of pension haircuts and economic lost decades.

John Mauldin has done it again, writing a comment on pensions where he at once informs and misinforms us.

First, let me begin by where I agree with John. Public pension liabilities are debts we owe to people who are looking to retire with a safe, secure defined-benefit pension.

John is absolutely right that total US debt ($22 trillion) does NOT include state and local debt ($3 trillion) which doesn't include the $6 trillion in unfunded pension liabilities.

How does that old saying go, "a trillion here, a trillion there, pretty soon we're talking real money!".

And as I keep warning my readers, the pension crisis made up of unfunded public pension liabilities and lack of private savings in 401(k) type of plans, is deflationary.

In fact, excessive debt is deflationary as it detracts from future economic growth.

Add to this the aging of societies and you have the perfect cocktail for a long-term pension crisis.

The Montreal Gazette recently discussed a PwC study which claims the aging population is hurting Quebec's economy. Well, guess what? Other provinces and states aren't faring any better.

Remember the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create. One study found that 800 million people might be out of a job by 2030 because of automation.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

This is why I'm definitely not in the inflation camp and think rising rates are being capped by these structural forces which shouldn't be confused with cyclical swings in inflation due to a depreciating currency.

Anyway, the point is John is right to worry about the pension train wreck but he also misses a great opportunity to talk to you about things that can help sustain public pensions over the long run.

Importantly, unlike John, I do not see this as a hopeless situation. Why? Because sooner or later the US and rest of the world (minus Denmark and the Netherlands) are all going to adopt two critical factors that have led to the long-term success of Canada's mighty pension plans:
  1. Adopt world-class governance which separates public pensions from governments completely, have them overseen by an independent and qualified board and managed by industry experts who are paid to deliver long-term excess returns investing across public and private markets all over the world. Most of this can be done internally, saving a bundle on fees.
  2. Adopt a shared risk model which ensures intergenerational equity and shares the risk properly between active and retired members. This way, when pensions run into trouble, it's not just active members paying more in contributions but also retired members that receive less benefits (typically, a small adjustment in their cost-of-living adjustment, they'll go a brief period without full inflation portection until the plan's funded status is fully restored).
Go read my recent comment on why OMERS is reviewing its indexing policy which is the right thing to do, making its plan young again like OTPP is doing.

There's no secret sauce to pension solvency. Asset returns alone cannot bring a plan back to fully funded status, not in a low growth, low rate, low return world. You need to adopt conditional inflation protection too or else you'll be swimming against the current.

But in the US, state and local governments aren't interested in world class governance or shared risk models. The ones suffering from chronic pension deficits are kicking the can down the road, something I discussed last week in my comment on why CPPIB is issuing green bonds:
Why is CPPIB issuing green bonds? It has over $356 billion under management and doesn't need the money so why is it issuing green bonds?

Cynics will claim it's just a green gimmick, another case of Canadian pensions cranking up the leverage to boost their returns and executive compensation.

Now, let's all take a deep breath in and out. I'll explain to you exactly why CPPIB wisely chose to issue green bonds.

First, it has nothing to do with leverage. CPPIB will invest $3 billion out of a total $356 billion so leverage isn't the reason behind issuing green bonds.

Second, it has everything to do with efficient use of capital. When a corporation issues a bond, it uses that money to buy back shares, invest in capital equipment or make a strategic acquisition, among other things.

When a pension issues a bond, any bond, it incurs liabilities and needs to invest that money wisely to earn a higher rate of return.

In the US, rating agencies are targeting underfunded public pensions and many of these state and local governments with chronically underfunded pensions are responding by kicking the can down the road, issuing pension bonds to invest and try to make up their shortfall.

It works like this. US state or local governments emit $100 million in pension obligation bonds, pay out 4.5% (assuming rates don't rise a lot) to investors and their public pensions use the proceeds to invest in stocks, corporate bonds, private equity funds and hedge funds to try to earn more than than that 4.5% being paid out (typically targeting a 7.5 or 8% bogey) to try to close the gap between assets and liabilities to improve its funded status.

And because a lot of the US state and local governments emitting pension obligation bonds are fiscally weak, their credit rating isn't very good so they need to pay an extra premium to investors to entice them to buy these pension bonds.

It's nuts when you think about it because they're taking credit risk (their own balance sheet can significantly deteriorate) and market risk (if interest rates rise or assets get clobbered), hoping they will invest wisely to earn more than what they're paying out to bondholders. This is why experts warn to beware of pension obligation bonds.

Are you with me so far? Great, because unlike US public pensions, Canada's large public pensions operate at arm's length from the government, enjoy a AAA credit rating because they're fully funded or close to it, they have world class governance, and are very transparent.

Their strong balance sheet and exceptional long-term track record allows them to emit bonds, any bonds, at a competitive rate as they receive a AAA rating, and then they can use those proceeds to target global investments across public and private assets all over the world.

So, issuing green bonds is nothing new, it's something old that only targets green investments, but the media reports make it sound like CPPIB is doing something way out of the ordinary.

It isn't. It's doing what it has done all along, what all of Canada's large pensions are doing, using their great balance sheet and long-term track record to emit bonds as rates are still at historic lows and use those proceeds to invest across global public and private markets to earn a better rate of return.

And they're not jacking up the leverage, at least CPPIB isn't relative to its overall portfolio. It simply boils down to efficient use of capital. That's it, that's all.
The pension obligation bond scam is going to come crashing down when the next financial crisis hits.

When will that be? That's the multi-trillion question but like John, I worry that the next "Big One" will be a lot rougher and last a lot longer.

Right now, it's steady as she goes, everyone keeps buying those FAANG stocks. I was listening to CNBC earlier today that Netflix (NFLX) is up almost 100% year-to-date and some analyst was saying it's going much, much higher and the same thing goes for Amazon (AMZN):



"Son, those are mighty bullish charts there, don't fight the trend, do what all the big hedge funds are doing and buy more of them FAANG stocks!"

Have you ever seen the movie "The Untouchables" where Robert De Niro plays mob boss Al Capone and takes out a baseball bat as he discusses "teamwork" with his lieutenants?



It's a gruesome scene but sometimes I think a lot of portfolio managers laughing it up, buying these FAANG stocks, playing momentum are going to get whacked so hard when they least expect it, it's going to clobber them and their unsuspecting investors.

But as we all know, markets can stay irrational longer than you can stay solvent, so keep dancing as long as the music is playing, just make sure you're hedging accordingly and taking money off the table when your positions run up a lot.

As far as the great pension train wreck, nothing to worry about yet, however, the sooner people realize the current course of action in the US isn't sustainable and they need to adopt elements of Canadian success (world class governance, shared risk model), the better off the US will be.

One thing I can tell you, beware of pension obligation bonds, they're bad for your fiscal and financial health. While CPPIB issues green bonds, US state and local governments are issuing more pension bonds. Watch Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

And don't believe all the bad news on US Social Security. Former Social Security Commissioner Mike Astrue discusses reports that Social Security is dipping into its reserves for the first time since 1982. Great discussion, he addresses many myths and alludes to the success of other countries "privatizing" their Social Security but doesn't talk about the success of the Canada Pension Plan.

Bottom line: The great pension train wreck is headed our way but the situation isn't as dire as John Mauldin and others make it out to be, at least not yet (that can easily change if a crisis whacks us).


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